The balance of trade forms part of the current account, which includes other transactions such as income from the net international investment position as well as international aid. If the current account is in surplus, the country’s net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.
Balance of Trade
Cumulative current account
balance 1980–2008 based on International Monetary Fund data.
Cumulative current account
balance per capita 1980–2008 based
on International Monetary Fund data.
The commercial balance or net
exports (sometimes symbolized as NX),
is the difference between the monetary value of exports and imports of output
in an economy over a certain period, measured in the currency of that economy.
It is the relationship between a nation’s imports and exports A positive
balance is known as a trade surplus
if it consists of exporting more than is imported; a negative balance is
referred to as a trade deficit or, informally, a trade gap.
The balance of trade is sometimes divided into a goods and a services balance.
Policies of early modern
Europe are grouped under the heading mercantilism. Early understanding of the
imbalances of trade emerged from the practices and abuses of mercantilism in
which colonial America’s natural resources and cash crops were exported in
exchange for finished goods from England, a factor leading to the American
Revolution. An early statement appeared in Discourse
of the Common Wealth of this Realm of England, 1549: “We must always take
heed that we buy no more from strangers than we sell them, for so should we
impoverish ourselves and enrich them Similarly a systematic and coherent
explanation of balance of trade was made public through Thomas Mun’s c1630
“England’s treasure by foreign trade, or, The balance of our foreign trade is
the rule of our treasure
Definition
The balance of trade forms
part of the current account, which includes other transactions such as income
from the net international investment position as well as international aid. If
the current account is in surplus, the country’s net international asset
position increases correspondingly. Equally, a deficit decreases the net
international asset position.
The trade balance is
identical to the difference between a country’s output and its domestic demand
(the difference between what goods a country produces and how many goods it
buys from abroad; this does not include money re-spent on foreign stock, nor
does it factor in the concept of importing goods to produce for the domestic
market).
Measuring the balance of
trade can be problematic because of problems with recording and collecting
data. As an illustration of this problem, when official data for the entire
world’s countries are added up, exports exceed imports by almost 1%; it appears
the world is running a positive balance of trade with itself. This cannot be
true, because all transactions involve an equal credit or debit in the account
of each nation. The discrepancy is widely believed to be explained by
transactions intended to launder money or evade taxes, smuggling and other
visibility problems. However, especially for developed countries, accuracy is
likely.
Factors that can Affect the Balance of Trade
Include
The cost of production (land,
labor, capital, taxes, incentives, etc.) in the exporting economy vis-à-vis those in the importing
economy;
The cost and availability of
raw materials, intermediate goods and other inputs; ➢ Exchange rate movements;
Multilateral, bilateral and
unilateral taxes or restrictions on trade;
Non-tariff barriers such as
environmental, health or safety standards;
The availability of adequate
foreign exchange with which to pay for imports; and
Prices of goods manufactured
at home (influenced by the responsiveness of supply)
In addition, the trade
balance is likely to differ across the business cycle. In export-led growth
(such as oil and early industrial goods), the balance of trade will improve
during an economic expansion. However, with domestic demand led growth (as in
the United States and Australia) the trade balance will worsen at the same
stage in the business cycle.
Monetary balance of trade is
different from physical balance of trade (which is expressed in amount of raw
materials, known also as Total Material Consumption). Developed countries
usually import a lot of raw materials from developing countries. Typically,
these imported materials are transformed into finished products, and might be
exported after adding value. Financial trade balance statistics conceal
material flow. Most developed countries have a large physical trade deficit,
because they have a large ecological footprint. Civil society organizations
point out the predatory nature of this imbalance, and campaign for ecological
debt repayment.
Since the mid-1980s, the
United States has had a growing deficit in tradable goods; especially with
Asian nations (China and Japan) which now hold large sums of U.S debt that has
funded the consumption The U.S. has a trade surplus with nations such as
Australia. The issue of trade deficits can be complex. Trade deficits generated
in tradable goods such as manufactured goods or software may impact domestic
employment to different degrees than trade deficits in raw materials.
Economies such as Japan and
Germany which have savings surpluses, typically run trade surpluses. China, a
high-growth economy, has tended to run trade surpluses. A higher savings rate
generally corresponds to a trade surplus. Correspondingly, the U.S. with its
lower savings rate has tended to run high trade deficits, especially with Asian
nations.
Views on Economic Impact
Classical Theory
From Classical economic
theory, those who ignore the effects of long run trade deficits may be
confusing David Ricardo’s principle of comparative advantage with Adam Smith’s
principle of absolute advantage, specifically ignoring the latter. The
economist Paul Craig Roberts notes that the comparative advantage principles
developed by David Ricardo do not hold where the factors of production are
internationally mobile.
Global labor arbitrage, a
phenomenon described by economist Stephen S. Roach, where one country exploits
the cheap labor of another, would be a case of absolute advantage that is not
mutually beneficial. In 2010, economist Ian Fletcher authored a significant
work entitled, Free Trade Doesn’t Work:
What Should Replace It and Why, where he has supported a strategic approach
to trade rather than an unconditional or unilateral approach
Small trade deficits are
generally not considered to be harmful to either the importing or exporting
economy. However, when a national trade imbalance expands beyond prudence
(generally thought to be several percent of GDP, for several years),
adjustments tend to occur. While unsustainable imbalances may persist for long
periods (cf, Singapore and New Zealand’s surpluses and deficits, respectively),
the distortions likely to be caused by large flows of wealth out of one economy
and into another tend to become intolerable.
In simple terms, trade
deficits are paid for out of foreign exchange reserves, and may continue until
such reserves are empty, at which point, the importer can no longer purchase
abroad. This is likely to have exchange rate implications: a loss of value in
the deficit economy’s currency relative to the surplus economy’s currency will
change the relative price of tradable goods, and facilitate a return to balance
or (quite commonly in historical data) an over-shooting into surplus, the other
direction.
When an economy is unable to
export enough physical goods to pay for its physical imports, it may be able to
find funds elsewhere: Service exports, for example, are more than sufficient to
pay for Hong Kong’s domestic goods import.
In poor countries, foreign
aid may compensate, while in developed economies a capital account surplus
caused by sales of assets often offsets a current-account deficit. There are
some economies where transfers from nationals working abroad contribute
significantly to paying for imports. The Philippines, Bangladesh and Mexico are
examples of transfer-rich economies.
A country may rebalance the
trade deficit by use of quantitative easing at home. This involves a central
bank printing money and making it available to other domestic financial
institutions at small interest rates, which increases the money supply in the
home economy. Inflation usually results, which devalues in real terms the debt
owed to foreign creditors if that debt was instantiated in the home currency.
Adam Smith on the Balance of Trade
“In the foregoing part of
this chapter I have endeavoured to show, even upon the principles of the
commercial system, how unnecessary it is to lay extraordinary restraints upon
the importation of goods from those countries with which the balance of trade
is supposed to be disadvantageous. Nothing, however, can be more absurd than
this whole doctrine of the balance of trade, upon which, not only these
restraints, but almost all the other regulations of commerce are founded. When
two places trade with one another, this [absurd] doctrine supposes that, if the
balance be even, neither of them either loses or gains; but if it leans in any
degree to one side, that one of them loses and the other gains in pro-portion
to its declension from the exact equilibrium.” (Smith, 1776, book IV, ch. iii,
part ii
Keynesian Theory
In the last few years of his
life, John Maynard Keynes was much preoccupied with the question of balance in
international trade. He was the leader of the British delegation to the United
Nations Monetary and Financial Conference in 1944 that established the Bretton
Woods system of international currency management.
He was the principal author
of a proposal – the so-called Keynes Plan — for an International Clearing
Union. The two governing principles of the plan were that the problem of
settling outstanding balances should be solved by ‘creating’ additional
‘international money’, and that debtor and creditor should be treated almost alike
as disturbers of equilibrium. In the event, though, the plans were rejected, in
part because “American opinion was naturally reluctant to accept the principle
of equality of treatment so novel in debtor-creditor relationships”.
His view, supported by many
economists and commentators at the time, was that creditor nations may be just
as responsible as debtor nations for disequilibrium in exchanges and that both
should be under an obligation to bring trade back into a state of balance.
Failure for them to do so could have serious consequences. In the words of
Geoffrey Crowther, then editor of The Economist, “If the economic relationships
between nations are not, by one means or another, brought fairly close to
balance, then there is no set of financial arrangements that can rescue the
world from the impoverishing results of chaos.”
These ideas were informed by
events prior to the Great Depression when – in the opinion of Keynes and others
– international lending, primarily by the U.S., exceeded the capacity of sound
investment and so got diverted into non-productive and speculative uses, which
in turn invited default and a sudden stop to the process of lending.
Influenced by Keynes,
economics texts in the immediate post-war period put a significant emphasis on
balance in trade. For example, the second edition of the popular introductory
textbook, An Outline of Money,
devoted the last three of its ten chapters to questions of foreign exchange
management and in particular the ‘problem of balance’. However, in more recent
years, since the end of the Bretton Woods system in 1971, with the increasing
influence of Monetarist schools of thought in the 1980s, and particularly in
the face of large sustained trade imbalances, these concerns – and particularly
concerns about the destabilizing effects of large trade surpluses – have
largely disappeared from mainstream economics discourse and Keynes’ insights
have slipped from view. They are receiving some attention again in the wake of
the financial crisis of 2007–2010
Monetarist Theory
Prior to 20th century
Monetarist theory, the 19th century economist and philosopher Frédéric Bastiat
expressed the idea that trade deficits actually were a manifestation of profit,
rather than a loss. He proposed as an example to suppose that he, a Frenchman,
exported French wine and imported British coal, turning a profit. He supposed
he was in France, and sent a cask of wine which was worth 50 francs to England.
The customhouse would record an export of 50 francs. If, in England, the wine sold
for 70 francs (or the pound equivalent), which he then used to buy coal, which
he imported into France, and was found to be worth 90 francs in France, he
would have made a profit of 40 francs. But the customhouse would say that the
value of imports exceeded that of exports and was trade deficit against the
ledger of France.
By reductio ad absurdum, Bastiat argued that the national trade
deficit was an indicator of a successful economy, rather than a failing one.
Bastiat predicted that a successful, growing economy would result in greater
trade deficits, and an unsuccessful, shrinking economy would result in lower
trade deficits. This was later, in the 20th century, echoed by economist Milton
Friedman.
In the 1980s, Milton
Friedman, a Nobel Prize-winning economist and a proponent of Monetarism,
contended that some of the concerns of trade deficits are unfair criticisms in
an attempt to push macroeconomic policies favorable to exporting industries.
Friedman argued that trade
deficits are not necessarily as important as high exports raise the value of
the currency, reducing aforementioned exports, and vice versa for imports, thus
naturally removing trade deficits not
due to investment. Since 1971, when the Nixon administration decided to
abolish fixed exchange rates, America’s Current Account accumulated trade
deficits have totaled $7.75 Trillion as of 2010. This deficit exists as it is
matched by investment coming into the United States- purely by the definition
of the balance of payments, any current account deficit that exists is matched
by an inflow of foreign investment.
In the late 1970s and early
1980s, the U.S. had experienced high inflation and Friedman’s policy positions
tended to defend the stronger dollar at that time. He stated his belief that
these trade deficits were not necessarily harmful to the economy at the time
since the currency comes back to the country (country A sells to country B,
country B sells to country C who buys from country A, but the trade deficit
only includes A and B). However, it may be in one form or another including the
possible tradeoff of foreign control of assets. In his view, the “worst case
scenario” of the currency never returning to the country of origin was actually
the best possible outcome: the country actually purchased its goods by
exchanging them for pieces of cheaply made paper. As Friedman put it, this
would be the same result as if the exporting country burned the dollars it
earned, never returning it to market circulation.
This position is a more
refined version of the theorem first discovered by David Hume. Hume argued that
England could not permanently gain from exports, because hoarding gold (i.e.,
currency) would make gold more plentiful in England; therefore, the prices of
English goods would rise, making them less attractive exports and making
foreign goods more attractive imports. In this way, countries’ trade balances
would balance out.
Friedman believed that
deficits would be corrected by free markets as floating currency rates rise or
fall with time to encourage or discourage imports in favor of the exports,
reversing again in favor of imports as the currency gains strength.
In the real world, a
potential difficulty is that currency markets are far from a free market, with
government and central banks being major players, and this is unlikely to
change within the foreseeable future. Nevertheless, recent developments have
shown that the global economy is undergoing a fundamental shift. For many
years, the U.S. has borrowed and bought while in general, the rest of the world
has lent and sold.
As of October 2007, the U.S.
dollar weakened against the euro, British pound, and many other currencies. For
instance, the euro hit $1.42 in October 2007, the strongest it has been since
its birth in 1999. Against this backdrop, American exporters are finding quite
favorable overseas markets for their products and U.S. consumers are responding
to their general housing slowdown by slowing their spending. Furthermore,
China, the Middle East, central Europe and Africa are absorbing more of the
world’s imports which in the end may result in a world economy that is more
evenly balanced. All of this could well add up to a major readjustment of the
U.S. trade deficit, which as a percentage of GDP, began in 1991.
Friedman contended that the
structure of the balance of payments was misleading. In an interview with
Charlie Rose, he stated that “on the books” the US is a net borrower of funds,
using those funds to pay for goods and services. He essentially claimed that
the foreign assets were not carried on the books at their higher, truer value.
Friedman presented his
analysis of the balance of trade in Free
to Choose, widely considered his most significant popular work.
Trade Balances Effects Upon Their Nation’s GDP
Annual trade surpluses are
immediate and direct additions to their nations’ GDPs.
To some extent exports’
induce additional increases to the GDPs that are not reflected within the
export products’ prices; thus trade surpluses contributions to their GDP are generally
understated.
Products’ prices generally
reflect their producers’ production supporting expenditures. Producers often
benefit from some production supporting goods and services at lesser or no cost
to the producers.
For example governments may
deliberately locate or increase the capacity of their infrastructure, or
provide other additional considerations to retain or attract producers within
their own jurisdictions.
Nations’ schools’ and
colleges’ curriculums may provide job applicants specifically suited to the
producer’s needs; or provide specialized research and development. Nations’
entire productions contribute to their GDPs but unless those goods and services
are entirely reflected within globaly traded products, theses other export
supporting productions are not entirely identified and attributed to their
nations’ global trade and they do additionally contribute to their nation’s
economy.
Annual trade deficits are
immediate and indirect reducers of their nations’ GDPs.
Trade deficits make no net
contribution to their nations’ GDPs but the importing nations indirectly deny
themselves of the benefits earned by producing nations; (refer to “Annual trade
surpluses are immediate and direct additions to their nations’ GDPs”). Among
what’s being denied is familiarity with methods, practices, the manipulation of
tools, materials and fabrication processes.
The economic differences
between domestic and imported goods occur prior to the goods entry within the
final purchasers’ nations. After domestic goods have reached their producers
shipping dock or imported goods have been unloaded on to the importing nation’s
cargo vessel or entry port’s dock, similar goods have similar economic
attributes.
Although supporting products
not reflected within the prices of specific items are all captured within the
producing nation’s GDP, those supporting but not reflected within prices of
globally traded goods are not attributed to nations’ global trade. Trade
surpluses’ contributions and trade deficits’ detriments to their nation’s GDPs
are understated. The entire benefits of production are earned by the exporting
nations and denied to the importing nation.
Balance of Payments
Balance of payments (BoP)
accounts are an accounting record of all monetary transactions between a
country and the rest of the world.[1] These transactions include payments for
the country’s exports and imports of goods, services, financial capital, and financial
transfers. The BOP accounts summarize international transactions for a specific
period, usually a year, and are prepared in a single currency, typically the
domestic currency for the country concerned. Sources of funds for a nation,
such as exports or the receipts of loans and investments, are recorded as
positive or surplus items. Uses of funds, such as for imports or to invest in
foreign countries, are recorded as negative or deficit items.
When all components of the
BOP accounts are included they must sum to zero with no overall surplus or
deficit. For example, if a country is importing more than it exports, its trade
balance will be in deficit, but the shortfall will have to be counterbalanced
in other ways – such as by funds earned from its foreign investments, by
running down central bank reserves or by receiving loans from other countries.
While the overall BOP
accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current
account, the capital account excluding the central bank’s reserve account, or
the sum of the two. Imbalances in the latter sum can result in surplus
countries accumulating wealth, while deficit nations become increasingly
indebted. The term “balance of payments” often refers to this sum: a country’s
balance of payments is said to be in surplus (equivalently, the balance of
payments is positive) by a specific amount if sources of funds (such as export
goods sold and bonds sold) exceed uses of funds (such as paying for imported
goods and paying for foreign bonds purchased) by that amount. There is said to
be a balance of payments deficit (the balance of payments is said to be
negative) if the former are less than the latter.
Under a fixed exchange rate
system, the central bank accommodates those flows by buying up any net inflow
of funds into the country or by providing foreign currency funds to the foreign
exchange market to match any international outflow of funds, thus preventing
the funds flows from affecting the exchange rate between the country’s currency
and other currencies. Then the net change per year in the central bank’s
foreign exchange reserves is sometimes called the balance of payments surplus
or deficit. Alternatives to a fixed exchange rate system include a managed
float where some changes of exchange rates are allowed, or at the other extreme
a purely floating exchange rate (also known as a purely flexible exchange
rate). With a pure float the central bank does not intervene at all to protect
or devalue its currency, allowing the rate to be set by the market, and the
central bank’s foreign exchange reserves do not change.
Historically there have been
different approaches to the question of how or even whether to eliminate
current account or trade imbalances. With record trade imbalances held up as
one of the contributing factors to the financial crisis of 2007–2010, plans to
address global imbalances have been high on the agenda of policy makers since
2009.
Composition of the Balance of Payments Sheet
BOP the two principal parts
of the BOP accounts are the current account and the capital account. The
current account shows the net amount a country is earning if it is in surplus,
or spending if it is in deficit. It is the sum of the balance of trade (net
earnings on exports minus payments for imports), factor income (earnings on
foreign investments minus payments made to foreign investors) and cash
transfers. It is called the current account as it covers transactions in the
“here and now” – those that don’t give rise to future claims
The Capital Account records
the net change in ownership of foreign assets. It includes the reserve account
(the foreign exchange market operations of a nation’s central bank), along with
loans and investments between the country and the rest of world (but not the
future regular repayments/dividends that the loans and investments yield; those
are earnings and will be recorded in the current account). The term “capital
account” is also used in the narrower sense that excludes central bank foreign
exchange market operations: Sometimes the reserve account is classified as
“below the line” and so not reported as part of the capital account.
Expressed with the broader
meaning for the capital account, the BOP identity assumes that any current
account surplus will be balanced by a capital account deficit of equal size –
or alternatively a current account deficit will be balanced by a corresponding
capital account surplus
The balancing item, which may
be positive or negative, is simply an amount that accounts for any statistical
errors and assures that the current and capital accounts sum to zero. By the
principles of double entry accounting, an entry in the current account gives
rise to an entry in the capital account, and in aggregate the two accounts
automatically balance.
A balance isn’t always
reflected in reported figures for the current and capital accounts, which
might, for example, report a surplus for both accounts, but when this happens
it always means something has been missed – most commonly, the operations of
the country’s central bank – and what has been missed is recorded in the
statistical discrepancy term (the balancing item).
An actual balance sheet will
typically have numerous sub headings under the principal divisions. For
example, entries under Current account might include:
Trade – buying and selling of
goods and services
Exports – a credit entry
Imports – a debit entry
Trade balance – the sum of
Exports and Imports
Factor income – repayments
and dividends from loans and investments
Factor earnings – a credit
entry
Factor payments – a debit
entry
Factor income balance – the
sum of earnings and payments.
Especially in older balance
sheets, a common division was between visible and invisible entries. Visible
trade recorded imports and exports of physical goods (entries for trade in
physical goods excluding services is now often called the merchandise balance).
Invisible trade would record international buying and selling of services, and
sometimes would be grouped with transfer and factor income as invisible
earnings.
The term “balance of payments
surplus” (or deficit – a deficit is simply a negative surplus) refers to the
sum of the surpluses in the current account and the narrowly defined capital
account (excluding changes in central bank reserves
Variations in the use of Term “balance of Payments”
Economics writer J. Orlin
Grabbe warns the term balance of payments can be a source of misunderstanding
due to divergent expectations about what the term denotes. Grabbe says the term
is sometimes misused by people who aren’t aware of the accepted meaning, not
only in general conversation but in financial publications and the economic
literature.
A common source of confusion
arises from whether or not the reserve account entry, part of the capital
account, is included in the BOP accounts. The reserve account records the
activity of the nation’s central bank. If it is excluded, the BOP can be in
surplus (which implies the central bank is building up foreign exchange
reserves) or in deficit (which implies the central bank is running down its
reserves or borrowing from abroad).
The term “balance of
payments” is sometimes misused by non-economists to mean just relatively narrow
parts of the BOP such as the trade deficit,[3] which means excluding parts of
the current account and the entire capital account.
Another cause of confusion is
the different naming conventions in use.[4] Before 1973 there was no standard
way to break down the BOP sheet, with the separation into invisible and visible
payments sometimes being the principal divisions.
The IMF has their own
standards for BOP accounting which is equivalent to the standard definition but
uses different nomenclature, in particular with respect to the meaning given to
the term capital account.
The IMF Definition
The International Monetary
Fund (IMF) use a particular set of definitions for the BOP accounts, which is
also used by the Organisation for Economic Co-operation and Development (OECD),
and the United Nations System of National Accounts (SNA).
The IMF uses the term current
account with the same meaning as that used by other organizations, although it
has its own names for its three leading sub-divisions, which are:
The goods and services
account (the overall trade balance)
The primary income account
(factor income such as from loans and investments)
The secondary income account
(transfer payments)
Imbalances
While the BOP has to balance
overall, [7] surpluses or deficits on its individual elements can lead to
imbalances between countries. In general there is concern over deficits in the
current account.[8] Countries with deficits in their current accounts will
build up increasing debt and/or see increased foreign ownership of their
assets. The types of deficits that typically raise concern are [1]
A visible trade deficit where
a nation is importing more physical goods than it exports (even if this is
balanced by the other components of the current account.)
An Overall Current Account Deficit
A basic deficit which is the
current account plus foreign direct investment (but excluding other elements of
the capital account like short terms loans and the reserve account.)
As discussed in the history
section below, the Washington Consensus period saw a swing of opinion towards
the view that there is no need to worry about imbalances. Opinion swung back in
the opposite direction in the wake of financial crisis of 2007–2009.
Mainstream opinion expressed
by the leading financial press and economists, international bodies like the
IMF – as well as leaders of surplus and deficit countries – has returned to the
view that large current account imbalances do matter.[9] Some economists do,
however, remain relatively unconcerned about imbalances[10] and there have been
assertions, such as by Michael P. Dooley, David Folkerts-Landau and Peter
Garber, that nations need to avoid temptation to switch to protectionism as a
means to correct imbalances.
Causes of BOP Imbalances
There are conflicting views
as to the primary cause of BOP imbalances, with much attention on the US which
currently has by far the biggest deficit. The conventional view is that current
account factors are the primary cause– these include the exchange rate, the
government’s fiscal deficit, business competitiveness, and private behaviour
such as the willingness of consumers to go into debt to finance extra
consumption. An alternative view, argued at length in a 2005 paper by Ben
Bernanke, is that the primary driver is the capital account, where a global
savings glut caused by savers in surplus countries, runs ahead of the available
investment opportunities, and is pushed into the US resulting in excess
consumption and asset price inflation.
Reserve Asset
The US dollar has been the
leading reserve asset since the end of the gold standard.
In the context of BOP and international
monetary systems, the reserve asset is the currency or other store of value
that is primarily used by nations for their foreign reserves.
BOP imbalances tend to
manifest as hoards of the reserve asset being amassed by surplus countries,
with deficit countries building debts denominated in the reserve asset or at
least depleting their supply. Under a gold standard, the reserve asset for all
members of the standard is gold. In the Bretton Woods system, either gold or
the U.S. dollar could serve as the reserve asset, though its smooth operation
depended on countries apart from the US choosing to keep most of their holdings
in dollars.
Following the ending of
Bretton Woods, there has been no de jure reserve asset, but the US dollar has
remained by far the principal de facto reserve. Global reserves rose sharply in
the first decade of the 21st century, partly as a result of the 1997 Asian
Financial Crisis, where several nations ran out of foreign currency needed for
essential imports and thus had to accept deals on unfavourable terms. The
International Monetary Fund (IMF) estimates that between 2000 to mid-2009,
official reserves rose from $1,900bn to $6,800bn.
Global reserves had peaked at
about $7,500bn in mid-2008, then declined by about $430bn as countries without
their own reserve currency used them to shield themselves from the worst
effects of the financial crisis. From Feb 2009 global reserves began increasing
again to reach close to $9,200bn by the end of 2010.
As of 2009, approximately 65%
of the world’s $6,800bn total is held in U.S. dollars and approximately 25% in
Euros. The UK pound, Japanese yen, IMF special drawing rights (SDRs), and
precious metals [19] also play a role. In 2009, Zhou Xiaochuan, governor of the
People’s Bank of China, proposed a gradual move towards increased use of SDRs,
and also for the national currencies backing SDRs to be expanded to include the
currencies of all major economies.[20] [21] Dr Zhou’s proposal has been
described as one of the most significant ideas expressed in 2009.
While the current central
role of the dollar does give the US some advantages, such as lower cost of
borrowings, it also contributes to the pressure causing the U.S. to run a
current account deficit, due to the Triffin dilemma. In a November 2009 article
published in Foreign Affairs magazine, economist C. Fred Bergsten argued that
Dr Zhou’s suggestion or a similar change to the international monetary system
would be in the United States’ best interests as well as the rest of the
world’s.[23] Since 2009 there has been a notable increase in the number of new
bilateral agreements which enable international trades to be transacted using a
currency that isn’t a traditional reserve asset, such as the renminbi, as the
Settlement currency.
Balance of Payments CRISIS
A BOP crisis, also called a
currency crisis, occurs when a nation is unable to pay for essential imports
and/or service its debt repayments. Typically, this is accompanied by a rapid
decline in the value of the affected nation’s currency. Crises are generally
preceded by large capital inflows, which are associated at first with rapid
economic growth. However a point is reached where overseas investors become
concerned about the level of debt their inbound capital is generating, and
decide to pull out their funds.[26] The resulting outbound capital flows are
associated with a rapid drop in the value of the affected nation’s currency.
This causes issues for firms of the affected nation who have received the
inbound investments and loans, as the revenue of those firms is typically
mostly derived domestically but their debts are often denominated in a reserve
currency. Once the nation’s government has exhausted its foreign reserves trying
to support the value of the domestic currency, its policy options are very
limited. It can raise its interest rates to try to prevent further declines in
the value of its currency, but while this can help those with debts denominated
in foreign currencies, it generally further depresses the local economy.
Balancing Mechanisms
One of the three fundamental
functions of an international monetary system is to provide mechanisms to
correct imbalances.
Broadly speaking, there are
three possible methods to correct BOP imbalances, though in practice a mixture
including some degree of at least the first two methods tends to be used.
These methods are adjustments
of exchange rates; adjustment of nation’s internal prices along with its levels
of demand; and rules based adjustment. Improving productivity and hence
competitiveness can also help, as can increasing the desirability of exports
through other means, though it is generally assumed a nation is always trying
to develop and sell its products to the best of its abilities.
Rebalancing by Changing the Exchange Rate
An upwards shift in the value
of a nation’s currency relative to others will make a nation’s exports less
competitive and make imports cheaper and so will tend to correct a current
account surplus. It also tends to make investment flows into the capital
account less attractive so will help with a surplus there too.
Conversely a downward shift
in the value of a nation’s currency makes it more expensive for its citizens to
buy imports and increases the competitiveness of their exports, thus helping to
correct a deficit (though the solution often doesn’t have a positive impact
immediately due to the Marshall–Lerner condition).
Exchange rates can be
adjusted by government in a rules based or managed currency regime, and when
left to float freely in the market they also tend to change in the direction
that will restore balance. When a country is selling more than it imports, the
demand for its currency will tend to increase as other countries ultimately [34]
need the selling country’s currency to make payments for the exports. The extra
demand tends to cause a rise of the currency’s price relative to others. When a
country is importing more than it exports, the supply of its own currency on
the international market tends to increase as it tries to exchange it for
foreign currency to pay for its imports, and this extra supply tends to cause
the price to fall. BOP effects are not the only market influence on exchange
rates however; they are also influenced by differences in national interest
rates and by speculation.
Rebalancing by Adjusting Internal Prices and Demand
When exchange rates are fixed
by a rigid gold standard, or when imbalances exist between members of a
currency union such as the Eurozone, the standard approach to correct
imbalances is by making changes to the domestic economy. To a large degree, the
change is optional for the surplus country, but compulsory for the deficit
country. In the case of a gold standard, the mechanism is largely automatic.
When a country has a favourable trade balance, as a consequence of selling more
than it buys it will experience a net inflow of gold. The natural effect of
this will be to increase the money supply, which leads to inflation and an
increase in prices, which then tends to make its goods less competitive and so
will decrease its trade surplus. However, the nation has the option of taking
the gold out of economy (sterilising the inflationary effect) thus building up
a hoard of gold and retaining its favourable balance of payments. On the other
hand, if a country has an adverse BOP it will experience a net loss of gold,
which will automatically have a deflationary effect, unless it chooses to leave
the gold standard. Prices will be reduced, making its exports more competitive,
and thus correcting the imbalance. While the gold standard is generally
considered to have been successful [36] up until 1914, correction by deflation
to the degree required by the large imbalances that arose after WWI proved
painful, with deflationary policies contributing to prolonged unemployment but
not re-establishing balance. Apart from the US most former members had left the
gold standard by the mid-1930s.
A possible method for surplus
countries such as Germany to contribute to re-balancing efforts when exchange
rate adjustment is not suitable is to increase its level of internal demand
(i.e. its spending on goods). While a current account surplus is commonly
understood as the excess of earnings over spending, an alternative expression
is that it is the excess of savings over investment
If a nation is earning more
than it spends the net effect will be to build up savings, except to the extent
that those savings are being used for investment. If consumers can be
encouraged to spend more instead of saving; or if the government runs a fiscal
deficit to offset private savings; or if the corporate sector divert more of
their profits to investment, then any current account surplus will tend to be
reduced. However in 2009 Germany amended its constitution to prohibit running a
deficit greater than 0.35% of its GDP and calls to reduce its surplus by
increasing demand have not been welcome by officials, adding to fears that the
2010s will not be an easy decade for the euro zone. In their April 2010 world
economic outlook report, the IMF presented a study showing how with the right
choice of policy options governments can transition out of a sustained current
account surplus with no negative effect on growth and with a positive impact on
unemployment
Rules Based Rebalancing Mechanisms
Nations can agree to fix
their exchange rates against each other, and then correct any imbalances that
arise by rules based and negotiated exchange rate changes and other methods.
The Bretton Woods system of fixed but adjustable exchange rates was an example
of a rules based system, though it still. John Maynard Keynes, one of the
architects of the Bretton Woods system had wanted additional rules to encourage
surplus countries to share the burden of rebalancing, as he argued that they
were in a stronger position to do so and as he regarded their surpluses as
negative externalities imposed on the global economy. [42] Keynes suggested
that traditional balancing mechanisms should be supplemented by the threat of
confiscation of a portion of excess revenue if the surplus country did not
choose to spend it on additional imports. However his ideas were not accepted
by the Americans at the time. In 2008 and 2009, American economist Paul
Davidson had been promoting his revamped form of Keynes’s plan as a possible
solution to global imbalances which in his opinion would expand growth all
rounds without the downside risk of other rebalancing methods
India’s Balance of Payments
Balance of Payments (BoP),
being a record of the monetary transactions over a period with the rest of the
world, reflects all payments and
liabilities to foreigners and all payments and obligations received from
foreigners. In this sense, the balance of payments is one of the major
indicators of a country’s status in international trade. BoP accounting serves
to highlight a country’s competitive strengths and weaknesses and helps in
achieving balanced economic-growth. It can significantly affect the economic
policies of a government and the economy itself. Therefore, every country
strives to a have a favorable balance of payments and maintains its long run
sustainability. India’s balance of payment position was quite unfavorable
during the time of country’s entry into liberalized trade regime. Two decades
of economic reforms and free trade opened several opportunities that, of
course, reflected in the balance of payments performance of the country. This
paper, therefore, attempts to evaluate the trends and emerging challenges of
India’s Balance of Payments. The discussion is broadly classified into four
parts viz.
India’s balance of payments picture since
1991,
emerging role of invisibles
and software services in balance of payments
unhealthy trends in FDI and iv) the vulnerability and challenges
ahead.
India’s Balance of Payments Picture Since 1991
Independent India’s external
trade and performance had faced severe threats many a times. The most
challenging one was that of 1991.The economic crisis of 1991 was primarily due
to the large and growing fiscal imbalances over the 1980s. India’s balance of
payments in 1990-91 was suffered from capital account problems due to a loss of
investor confidence. The widening current account imbalances and reserve losses
contributed to low investor confidence putting the external sector in deep
dilemma. During 1990-91, the current account deficit steeply hiked to $-9680
million while the capital account surplus was far below at $ 7188 million. This
led to an ever time high deficit in BoP position of India.
India initiated economic
reforms to find the way out of the growing crisis. Structural measures
emphasized accelerating the process of industrial and import delicensing and
then shifted to further trade liberalization, financial sector reform and tax
reform. Prior to 1991, capital flows to India predominately consisted of aid
flows, commercial borrowings, and nonresident Indian deposits. Direct
investment was restricted, foreign portfolio investment was channeled almost
exclusively into a small number of public sector bond issues, and foreign
equity holdings in Indian companies were not permitted (Chopra and others,
1995). However, this development strategy of both inward-looking and highly
interventionist, consisting of import protection, complex industrial licensing
requirements etc underwent radical changes with the liberalization policies of
1991.
The post reform period really
eased India’s struggles with regard to external sector. This is evident from
the RBI data summarizing the BOP in current account and capital account. The
current account which measures all transactions including exports and imports
of goods and services, income receivable and payable abroad, and current
transfers from and to abroad remained almost negative throughout the post
reform period except for the three financial years. Until 2000-01, the current
account deficit that comprises both trade balance and the invisible balance,
remained stagnant and stood around $ 5000 million. However, for the first time
since 1991, the current account recorded surplus in its account during three
consecutive financial years
From 2001-02, the deficit in
current account continued to occur from 2004-05 onwards and the growth rate was
comparatively faster. Surprisingly, the current account deficit grew like
anything since 2007-08, the period witnessed financial crisis. The current
account balance of India during 2011-12 is recorded to be $ - 78155 million,
signifying a deficit eight times that of the figures of 2007-08. Huge negative
debits and comparatively low positive credits caused for this negative value in
current account. Another notable feature of current account balance is that the
deficit was mounting during the previous years. Two major items of current
account are merchandise and the invisibles. These two items generate the value
of current account balance of the country. The net merchandise has been always
found to be huge negative figure. During 2011-12 it was recorded to be $ -
189759 million. During the same period, our total merchandise credit was $ 309774
million while our merchandise debit was $ 499533 million. This is a common
feature of India’s merchandise figures during all the years.